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23 April 2018

Keeping Things in Perspective in the U.S. Market

We often say that panic is not an investing strategy, but the media often takes the opposite view, as they breathlessly rush to report “breaking news” and add “markets in turmoil” specials after particularly volatile days. It must work to gain viewers or they wouldn’t do it but we suggest that investors would be better served taking a step back, keeping emotions in check and maintaining discipline. Fundamentally, our view expressed in our 2018 outlook was that U.S. market volatility would escalate this year—consistent with late-cycle economic and market tendencies.

One effect of the recent volatility has been to further dent investor sentiment—a contrarian indicator at extremes. Overly-optimistic sentiment had been a factor behind our more cautious outlook for 2018, so an easing of the froth which had accompanied the January all-time highs for the major equity indexes is welcome. According to the Ned Davis Research Crowd Sentiment Poll, conditions have moved from the extreme optimism zone, to the cusp of the extreme pessimism zone. The recent selling has also helped to partly alleviate expensive valuations as the forward price/earnings ratio (P/E) for the S&P 500, according to Thomson Reuters, has moved from more than 18 to roughly 16 today—not cheap historically but much closer to median levels historically.

Economy and earnings should regain the spotlight

With all the action surrounding the trade issues and headlines coming from the tech sector, it seems that economic developments have moved to the back burner, while earnings season is also beginning with less fanfare than typically seen. Recently, there have been some weaker economic releases, which is not surprising given the tendency over the past 20 years for first quarter weakness, followed by a pick-up in the second quarter. In fact, the Bureau of Economic Analysis (BEA) continues to grapple with the persistence of seasonal patterns affecting growth in the first quarter so frequently.

Pressure on Fed remains low…for now

The Federal Reserve continues its “normalization” campaign, with ongoing balance sheet withdrawal and likely at least three total rate hikes this year. For now, inflation has remained relatively contained, with the Consumer Price Index (CPI) rising a modest 2.1% year-over-year at the core level, excluding food and energy, in March. With a tight labor market and continued economic growth—combined with the tailwind of tax cuts and the moving of company cash held overseas to the United States—inflation is likely to accelerate further, which is a market risk that investors may be overlooking. If inflation heats up, the Federal Reserve may have to become more aggressive, which in turn would likely negatively impact the market. Valuations tend to fall under the pressure of inflation given that earnings are less valuable when inflation is rising.

From trade war to actual war?

Market worries broadened this past week from fears of a trade war to an actual war, or at least a military strike. Markets had an initial negative reaction when President Trump warned Russia to “get ready” for a U.S. missile strike on Syria over a suspected chemical weapons attack. Airstrikes take place almost daily as part of ongoing campaigns, but focused initial missile strikes and military operations can have an abrupt impact on markets. There is a long history of U.S. missile strikes in the past 25 years we can use to assess the potential market impact. In short, history shows us that the impacts of these geopolitical conflicts have been small and brief.

The stock market reaction was most often slightly negative on the first day of missile strikes, with the markets recovering the losses within five days in most instances. Following the two prior U.S. strikes on Syria, stocks were still down five days later, but those declines began before the strikes and appeared driven by economic data. Larger losses of around 5% took place when the strikes occurred during the Asian financial crisis in 1998 and the global financial crisis in 2008. Typically, gold futures, the dollar and bond yields were little changed while oil prices tended to rise. That seems to be playing out in anticipation of the strikes with an initial negative reaction in stock markets while oil prices advanced to the highest level since 2014.

So what?

Investors are best served when grim headlines are in the news by again keeping things in perspective and remembering that geopolitical risks are a regular part of investing and that a long history of geopolitical developments shows us that holding a well-diversified portfolio may buffer the short-term market moves than are most often the result. Investors should avoid overreacting to geopolitical developments and stick to their long-term financial plans.

Important Disclosure

Investment involves risk. Past performance is no indication of future results, and values fluctuate. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.

Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.

The S&P 500 Composite Index is a market capitalization-weighted index of 500 of the most widely-held U.S. companies in the industrial, transportation, utility, and financial sectors.

Ned Davis Research (NDR) Sentiment Poll shows perspective on a composite sentiment indicator designed to highlight short- to intermediate-term swings in investor psychology.

The Consumer Price Index (CPI) is an index that measures the weighted average of prices of a basket of consumer goods and services, weighted according to their importance.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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